Question

Bird Enterprises has no debt. Its current total value is $49 million. Assume debt proceeds are used to repurchase equity. a. Ignoring taxes, what will the company’s value be if it sells $19.4 million in debt? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, round your answer to the nearest whole number, e.g., 1,234,567.) b. Suppose now that the company’s tax rate is 25 percent. What will its overall value be if it sells $19.4 million in debt? (Do not round intermediate calculations and enter your answer in dollars, not million

Answer 1

a) As per Modigilani Approach, value of the enterprise does not depend on the capital structure of the firm. This preposition assumes no tax environment. The approach assumes that any reduction on cost of debt, in turn increases the cost of equity such that overall cost of capital is unchanged thereby the value of the firm is unchanged.

Hence even if debt is used to pay off equity, value of firm will remain unchanged at $49,000,000

b) Under the Second Preposition, the value of the firm will increase if the tax picture is considered. Hence value of firm will only increase by the tax portion of debt

Hence Revised Value of Firm = Value with no debt + Tax * Debt

= 49 + 19.4*25% = $ 53.85 million i.e 53,850,000